Tuesday, February 26, 2013

This morning I sold another chunk of my iShares bond ETF, CLF, and purchased 100 shares of Power Financial Corporation First Preferred Shares, Series S, at $25 per share. The current yield is 4.80%, just slightly higher than the common shares of PWF. The shares are rated Pfd-1 by DBRS, and P-1 by S&P, which are considered highest quality ratings.

Power Financial Corp. (PWF)

Preferred shares (PF Shares) from Canada’s biggest companies are rarely offered with TD Waterhouse, and these new issues are usually gone within 20 to 30 minutes. I have been planning for several months to start adding PF shares to my portfolio, so when I received the email for PWF PF Series S this morning, I moved quickly. Only a few minutes after purchasing, the issue was closed. The shares were bought at the standard issue price for PF shares at $25 per share. This is my first purchase of preferred shares for my portfolio, and likely there will be more in the years to follow, especially in retirement.

Power Financial Corporation (PWF)

Power Financial Corporation (PWF), and its parent holding company Power Corp. (POW), is one of Canada’s largest financial conglomerates. PWF was one of my 2012 Stock Picks. Power Financial (PWF) is a 20.9 billion dollar holding company that has interests in Great-West Lifeco Inc., London Insurance Group, Canada Life Financial Corporation, Putnam Investments, IGM Financial Inc., Investors Group Inc., and Mackenzie Financial Corp. You’ll recognize Investors Group and Mackenzie as two of Canada’s leading mutual fund companies, which are actually owned by IGM Financial.

Preferred Shares, Bonds, and Trade Offs

Back in January 2011, I wrote an article on the power of preferred shares. It’s important to understand that preferred shares are not bonds, nor should they replace bonds in your portfolio. However, they can certainly be considered a fixed-income investment. They do have many similarities to bonds, such as a fixed rate of return, low volatility, and returns tied into interest rates etc. Retirees have long enjoyed preferred shares for their consistent dividend income and low volatility. For non-registered accounts where the dividends receive tax favourable treatment, preferred shares have been a winning investment.

One of the drawbacks of preferred a share is they are “redeemable”, much like a corporate bond that is “callable”. That means they can be called back by the company at their discretion. However a premium is offered if that should occur, usually a $1 per share premium for the first five years prorated down to $0 over a ten year period. At the very least, the company will buy back your shares for the face value of $25 if they choose to redeem them. As long as you don’t sell your shares, especially with an interest rate increase, the chance of loss is minimal in my opinion.

The trade off is of course, is you don’t get the growth of your investment as you would with common shares. This is why many consider preferred shares as fixed-income investments – you get the higher yield in return for capital growth.

Preferreds and Interest Rates

The other trade off, like bonds, is an increase in interest rates. In a Globe and Mail article last September, Preferred Shares: How to navigate rising rates, Rob Carrick wrote on the differences between “perpetual” preferred shares, and “rate reset” preferred shares.

The type of preferred share I purchased today, termed a “perpetual” share, is the most sensitive to interest rate increases. These types of preferred shares pay a continuous dividend until either they are redeemed (called back by the issuer) or sold. In the worst case scenario you could end up holding a preferred share with a rate far below a GIC and a share value well below the issue price.

The other type of preferred share is termed a “rate reset” and is considered the better of the preferred shares to purchase. That’s because the issuer of the preferred share has the option to change the rate on the shares. In an increasing interest rate environment, that’s a win, because most issuers would increase the rate of their rate-reset preferreds, or simply call them back.

Conclusion

If interest rates do increase, preferred shares may offer less volatility to my portfolio than bonds. This would especially be so if I can build a ladder of “rate reset” rather than “perpetual” preferreds. If interest rates do not increase anytime soon, then 4.80% with low volatility is a pretty sweet deal.

Preferred shares will also smooth out market volatility on the equity side of my portfolio, while providing income. In addition, the common stock for Power Financial Corp. (PWF) has been on my watch list for a long time, and a company I nearly purchased back in December 2011. So although I would have “preferred” a “rate reset” issue, I’m pleased to add PWF Series S to my portfolio.

Readers what’s your take? Do you own preferred shares in your portfolio?

This article was written by Dividend Ninja. If you enjoyed this article, please subscribe to his feed [RSS]